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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2016

Don’t Disturb Underwriting

Hotel lenders should seek professional hospitality-project guidance

Don’t Disturb Underwriting

Many endeavors in life depend on getting the right feedback at the right time. Navigating your way to a new location, for example, is far easier when you can plug the address into a mobile app and follow directions.

Likewise, commercial mortgage brokers seeking hotel-renovation financing for clients have a better chance of ensuring these loans are underwritten wisely if they work with lenders that are guided by hospitality-project consultants.

Hotels take a lot of physical abuse and should be renovated over time. Typically, the renovation cycle runs from seven to 10 years. When hotels are bought and sold, the hotel’s sponsoring brand — i.e., Sheraton, Marriott, Hilton — gets involved in the transaction.

Specifically, the hotel buyer must negotiate a franchise agreement with the chosen hotel brand. Part of the negotiation involves the plans for renovating the property so that it meets the hotel brand’s franchise requirements.

Consequently, in many cases, there is a “change of ownership” renovation plan that must be prepared. This plan is critical to a commercial mortgage lender because the condition of the hotel becomes critical in the case of a default as well as in ensuring a steady flow of business for the hotel. Commercial mortgage brokers who understand this process can better match the borrower with the right lender and promote a smoother loan-approval process.

Hotels are unique properties in that they are one of the few asset types in the real estate sector with a 24-hour operating cycle. Hotel rates and revenues change every day as well. The hotel sector also has a tendency to experience seven- to nine-year economic cycles and typically is the first to feel economic pressures. This heavily management-dependent business has grown significantly in the past seven years.

The renovation plan

There are two main types of hotel real estate: full service and limited service. There are many different brands and plenty of other differences, but a full-service hotel, besides lodging, offers a full range of other services — including restaurants, lounges, bellmen, room service, banquets, a group-function space, etc. The size of such a hotel generally exceeds 200 rooms.

Limited-service hotels, by contrast, generally feature fewer than 150 rooms and few additional frills, compared with full-service properties. Margins are much higher for limited-service hotels, but total revenues are much lower relative to full-service properties.

For both, the mortgage process begins when a hotel buyer or owner asks for a loan. Commercial mortgage lenders and brokers have to cope with many new rules and guidance about debt, but that is the business of lending money, and it needs to be available to grow hospitality projects. The mortgage for a hotel property is dependent on many factors, but one of the important ones involves the renovation plan.

The hotel flag, or brand, that a hotel owner chooses to affiliate with typically requires that the hotel property be renovated to qualify for a franchise agreement. This agreement is critical to the loan because it protects and enhances the lender’s collateral.

The lender should get a good handle on the real cost of this required renovation, the details of which are supposed to be outlined through a proposal called the Property Improvement Plan, or PIP. The PIP is vital to ensuring the preservation of the hotel and is key to getting a franchise agreement approved.

Welcome to the commercial mortgage lender’s challenge. Where do you begin? Whom do you trust? How do these PIP’s get completed? How can a lender be sure there is enough capital set aside to complete the requirements for the hotel brand’s franchise pact? How can the mortgage company’s staff find the professionals to advise them?

Expert help

The murky world of hotel renovation needs a lot of explanation. Commercial mortgage lenders often do not know where to go to get the answers they need. The lender must find professional consulting resources that can answer questions about the planned renovation.

Hotels are unique properties in that they are one of the few asset
types in the real estate sector with a 24-hour operating cycle.

What reliable resources are out there to help lenders protect the deal’s collateral? To whom can commercial mortgage lenders turn when they need answers that are critical to this key aspect of their underwriting?

There are plenty of companies that do hospitality project management professionally. Some, not many, also have a history that includes operating hotels. It is critical that the project manager chosen to assist and guide the lender understands the hospitality business — and ideally has some operating experience in the hotel industry or staff members who understand the hotel business.

A good fit for a lender is a project manager or consultant with such expertise who also has strong contacts with the major hotel brands. Typically, companies awarding hotel flags ask for more than what is necessary in the renovation of the hotel. Negotiations with the hotel-branding company, therefore, can result in significant waivers, which eliminate costs for unnecessary work.

Avoiding purchases of expensive furniture, carpet and lighting is vital to budgeting, so finding a project manager with a background in purchasing is a plus. Such a partner also can suggest what a local hotel needs on the renovation front far better than an out-of-state hotel company that is offering the franchise pact. Drawing on that project manager’s experience can keep a change-of-ownership PIP in line with the lender’s underwriting requirements.

Commercial mortgage lenders should seek out project-management experts who understand that the PIP is only a part of the renovation costs related to repositioning the property. The lender, to have true protection for collateral, should work with groups that create “property-renovation plans” that include improvements to infrastructure as well, for example.

Critical infrastructure components include items such as heating, ventilation and air-conditioning equipment; washers and dryers; boilers; kitchen equipment and much more. These items, along with roofs, elevators, windows; parking lots, etc., are not typically addressed in the PIP. Should these areas need upgrading, but go unaddressed during the renovation, there could be additional expenses incurred in the future operation of the hotel.

Frequently, these future expenses can negatively affect net operating income and covenants linked to the debt-service coverage ratio — or could even lead to loan-default issues. A commercial mortgage lender, therefore, should work with a project manager who can help avoid these scenarios.

Lenders should seek out hospitality management groups that have an “orchestra/conductor” philosophy and can assemble and coordinate the best team of professionals needed to assure a successful property renovation. This team, collectively, should have expertise in the following:

  • Design;
  • Purchasing;
  • Architecture;
  • Logistics;
  • Construction management;
  • Accounting; and
  • Legal issues.

The project-management team chosen to guide the lender should present a plan that improves the hotel per the guidelines of the franchise agreement; identifies infrastructure needs and related costs; and establishes purchasing budgets before bidding. The right resources have to be assembled for each project. It’s important, however, to understand that design alone does not create successful hotels. There’s a lot more involved. So overspending on design generally does not create additional hotel revenue.

•  •  •

Lenders underwrite a project based on the projections of revenues and profits. Overspending during a renovation typically hurts longer-term revenues and profits. Commercial mortgage brokers who work with lenders that are guided by hospitality-management experts will have an edge in closing more hotel-loan deals. In addition, this collaboration helps to advance the long-term financial prospects of the properties.



 


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